Painted Pony Is One Fast Growing Ponyhttps://seekingalpha.com/article/3931026-painted-pony-one-fast-growing-pony?auth_param=17k8gi:1bd1cgj:4ba1b75379e53d809f8783d782f450d5&uprof=45&dr=1 Summary The share price has recently fallen off to absurd levels. The company continues to execute its future growth plans and recently slashed total capex to 2019 by C$6 billion. I believe PPY could be bought out for C$14.50 in a takeout scenario in 2018. Summary Painted Pony (OTCPK:PDPYF) is an interesting E&P name that I like. It is particularly interesting because the management team has set out quite an ambitious goal of growing to 110,000 boe/d from its current 17,500 boe/d of production by Q4 of 2019. It is going to achieve these targets by taking on an additional C$360 million in debt on a total capex program of C$1.3 billion. The capex guidance has decreased considerably from C$1.9 billion earlier last year to C$1.3 billion thanks to servicing cost compression, so PPY has taken advantage in a downturn to scale up its productions cheaply. Business Background Painted Pony is a natural gas and natural gas liquids production company based in the Montney Formation in Northeast British Columbia. This small E&P company surprisingly has one of the highest natural gas reserves in Canada. Obviously, these are 2014 numbers, reserve data has not been released yet for year-end 2015, and I will subsequently update once the information is released. I actually expect PPY to grow reserves for 2015, and the total value of the company relative to its current price probably widened a bit more. In PPY's 2016 forecast, it's estimated that the company will produce 40k boe/d of production at Q4 2016 exit. The production will come online thanks to the 1st AtlaGas Townsend Facility that will provide up to 150 mmcf/d of processing. Given 2016's guidance, current STRIP pricing indicates that the company will need to take on additional debt to finance the drilling activity. The company breaks down what its leverage ratio would look like using current STRIP and capex budget. It will be a bit concerning to see that Q2 of 2016 would result in a 5.7x net debt to annualized Q2 cash flow. Part of the reason is due to depressed natural gas prices as it represents 95% of PPY's production volume. But as pricing gets better along the curve, the debt to cash flow ratio significantly improves. The credit line is also set to increase to C$325 million from C$225 million on October 31, 2016, and the renewal expected date is May 2017. This credit line increase should provide ample liquidity for PPY to cover its 2016 and 2017 capex budget. Growth following the expansion to 48k boe/d will require an additional C$135 million in added debt, and I believe the likelihood of further increasing the line to be high given the expanded reserve base through increased productions. Another particular appeal to PPY is the micro aspect of the business that could drive value creation for shareholders in the coming years. While top line is primarily dictated by the fluctuations in oil and natural gas prices, G&A and operating cost per boe will decrease as the company continues to remain lean while expanding productions. G&A costs per boe have decreased from C$2.73/boe in 2013 down to C$1.72/boe in 2015. PPY expects to keep the same number of people on board while continuing to grow productions from 17.5k boe/d to 22k boe/d. This effect causes costs per boe to decrease as it's a fixed cost, while the productivity of the staff increases thus reducing unit cost. The same thing is happening on the operating cost front. As productions increase from 17.5k boe/d to 40k boe/d at the end of 2016, unit cost economics scales in and reduces costs by nearly 36%. Valuation Painted Pony is trading at a particularly attractive valuation relative to both its future growth prospects and reserve base. As of this writing, PPY traded at about C$25k per flowing boe/d. Given that it's expecting to exit 2016 with nearly 40k boe/d in production, it trades at (including added debt) C$14k per flowing boe/d. That's particularly attractive given peers like Advantage trades at C$40k per flowing boe/d and Peyto trades at C$60k per flowing boe/d. While both peers have much lower cost profiles of less than C$6 boe/d all in cash cost, PPY will get there by 2017. What's also interesting to note is that if PPY decided not to expand aggressively to 110k boe/d of production in 2019, and chose to keep production flat in 2017. This is what it would look like. While in 2017, it would still outspend operating cash flow, it would generate almost C$89 million in free cash flow in 2018 at STRIP pricing. At today's valuation, PPY trades at 4.33x P/FCF and this assumes no increases in commodity prices. The crazy thing about this is that most E&P companies in this space will have a difficult time in even generating free cash flow due to the cost of replacing production being too high. I think for PPY to be able to generate that kind of free cash flow if it just remained flat is quite impressive. Another scenario to take a look at is in the case of an acquisition. Given PPY's giant reserve base, it makes sense for a strategic acquirer like Arc Energy to step in and buy out PPY. In 2015, one of PPY's peers, Kicking Horse, was bought out for almost ~C$85k per flowing boe/d. Half of Kicking Horse's production was liquids so the premium is due to higher netbacks. Let's assume that PPY gets bought out in 2018 at half the price Kicking horse was bought out for or C$40k per flowing boe/d on 47k boe/d of production. Debt would rise from the current C$64.9 million to C$203.9 million. Shares prices would fetch ~C$14.50 per share or a return of 275%. The buyer would be able to take PPY's reserves and produce it faster as it would be able to spend more capex on the field. Risks Natural gas prices remain depressed. Natural gas prices could remain depressed around $2.00/mcf resulting in lower netbacks. PPY uses aggressive hedging methods to ensure that the capex it spends today is based on locked in prices. Hedging will ensure that a proper return is guaranteed on the growth capex being spent, so part of the natural gas risk is insulated from this. However, if prices remain around $2.00/mcf, I fear that there aren't very many producers in North America that will make a profit. The few like Advantage (NYSE:AAV) and Peyto (OTCPK:PEYUF) may remain profitable even at $2 gas, but the price of natural gas shouldn't linger around $2/mcf for long as producers cut back while demand increases. Marcellus gas pushing Canadian gas away. Investors should also be aware that the Marcellus is becoming the juggernaut of the U.S. natural gas play. With the expanded takeaway capacity being built over the next few years, there's a decent probability that this influx of cheap gas could decrease Canadian gas prices (AECO). This, in turn, could cause producers in Canada to struggle. However, given that the cost profile of the Montney is very similar to that of the U.S. shale plays, the risks of being uncompetitive remains low. Conclusion I find PPY to possess a lot of the qualities a great E&P company has. PPY has a great asset base, a declining cost profile, low debt to cash flow ratios, and a management team that has outperformed operationally. There are fundamental shifts in the business that would allow it to earn more money even if commodity prices remain where they are. I believe PPY should be able to execute its projections with no issues and if it can get to 47k boe/d. In a takeout scenario, I believe PPY could fetch C$14.50 per share. PPY is a bargain. Source: https://paintedpony.ca/investors/presentations/default.aspx https://s2.q4cdn.com/513538771/files/doc_presentations/2016/02122016-Investor-Update-PDF.pdf Disclosure: I am/we are long PPY.TO.